Wednesday, August 28, 2013

I pretty much agree with everything Mark Thoma says here in pointing to sociological factors within academic economics as the source of recent problems. Anyone who has read this blog knows I'm not so sanguine about the supposed "sophistication" of the analytical models currently used in macroeconomics, but, that to one side, Thoma is right that the real problem has been a lack of imagination and willingness to build models (probably messy and inelegant ones) that would inform us in a practically useful way about possible market instabilities:

"I talked about the problem with the sociology of economics awhile back -- this is from a post in August, 2009:

In The Economist, Robert Lucas responds to recent criticism of
macroeconomics ("In
Defense of the Dismal Science"). Here's my entry at Free Exchange's Robert
Lucas Roundtable in response to his essay:

I agree that the analytical tools economists use are not the problem. We
cannot fully understand how the economy works without employing models of
some sort, and we cannot build coherent models without using analytic tools
such as mathematics. Some of these tools are very complex, but there is
nothing wrong with sophistication so long as sophistication itself does not
become the main goal, and sophistication is not used as a barrier to entry
into the theorist's club rather than an analytical device to understand the
world.

But all the tools in the world are useless if we lack the imagination
needed to build the right models. Models are built to answer specific
questions. When a theorist builds a model, it is an attempt to highlight the
features of the world the theorist believes are the most important for the
question at hand. For example, a map is a model of the real world, and
sometimes I want a road map to help me find my way to my destination, but
other times I might need a map showing crop production, or a map showing
underground pipes and electrical lines. It all depends on the question I
want to answer. If we try to make one map that answers every possible
question we could ever ask of maps, it would be so cluttered with detail it
would be useless, so we necessarily abstract from real world detail in order
to highlight the essential elements needed to answer the question we have
posed. The same is true for macroeconomic models.

But we have to ask the right questions before we can build the right
models.

The problem wasn't the tools that macroeconomists use, it was the
questions that we asked. The major debates in macroeconomics had nothing to
do with the possibility of bubbles causing a financial system meltdown.
That's not to say that there weren't models here and there that touched upon
these questions, but the main focus of macroeconomic research was elsewhere.
...
The interesting question to me, then, is why we failed to ask the right
questions. For example,... why policymakers didn't take the possibility of a
major meltdown seriously. Why didn't they deliver forecasts conditional on a
crisis occurring? Why didn't they ask this question of the model? Why did we
only get forecasts conditional on no crisis? And also, why was the main
factor that allowed the crisis to spread, the interconnectedness of
financial markets, missed?

It was because policymakers couldn't and didn't take seriously the
possibility that a crisis and meltdown could occur. And even if they had
seriously considered the possibility of a meltdown, the models most people
were using were not built to be informative on this question. It simply
wasn't a question that was taken seriously by the mainstream.

Why did we, for the most part, fail to ask the right questions? Was it
lack of imagination, was it the sociology within the profession, the
concentration of power over what research gets highlighted, the inadequacy
of the tools we brought to the problem, the fact that nobody will ever be
able to predict these types of events, or something else?

It wasn't the tools, and it wasn't lack of imagination. As Brad DeLong
points out, the voices were there—he points to Michael Mussa for one—but
those voices were not heard. Nobody listened even though some people did see
it coming. So I am more inclined to cite the sociology within the profession
or the concentration of power as the main factors that caused us to dismiss
these voices.

And here I think that thought leaders such as Robert Lucas and others who
openly ridiculed models they disagreed with have questions they should ask
themselves (e.g. Mr Lucas saying "At research seminars, people don’t take
Keynesian theorizing seriously anymore; the audience starts to whisper and
giggle to one another", or more recently "These are kind of schlock
economics"). When someone as notable and respected as Robert Lucas makes fun
of an entire line of inquiry, it influences whole generations of economists
away from asking certain types of questions, some of which turned out to be
important. Why was it necessary for the major leaders in macroeconomics to
shut down alternative lines of inquiry through ridicule and other means
rather than simply citing evidence in support of their positions? What were
they afraid of? The goal is to find the truth, not win fame and fortune by
dominating the debate.

We need to take a close look at how the sociology of our profession led
to an outcome where people were made to feel embarrassed for even asking
certain types of questions. People will always be passionate in defense of
their life's work, so it's not the rhetoric itself that is of concern, the
problem comes when factors such as ideology or control of journals and other
outlets for the dissemination of research stand in the way of promising
alternative lines of inquiry.

I don't know for sure the extent to which the ability of a small number
of people in the field to control the academic discourse led to a
concentration of power that stood in the way of alternative lines of
investigation, or the extent to which the ideology that markets prices
always tend to move toward their long-run equilibrium values caused us to
ignore voices that foresaw the developing bubble and coming crisis. But
something caused most of us to ask the wrong questions, and to dismiss the
people who got it right, and I think one of our first orders of business is
to understand how and why that happened.

I think the structure of journals, which concentrates power within the
profession, also influence the sociology of the profession (and not in a good
way)."

Tuesday, August 27, 2013

Several years ago, immediately post-crisis, I wrote a short article for Nature exploring new ideas about modelling economic and financial systems. I wrote about agent-based models and other similar ideas, nothing all that earth shaking really. In an early draft, I recall adding a section toward the end of the piece making the point that, of course, better models, better science, etc., would never be enough because ultimately policy making has an irreducible political element; financial crises can almost always be traced back to the political influence of powerful forces who shape policies to help themselves (or to try to do so), with little thought for the welfare of others. To my surprise, my editor at Nature took that section out saying something like "we'd like to stick to the science."

I thought that was unfortunate and hugely misleading. Corruption is real, and I really do think that no amount of better economics will eliminate financial and economic crises, because of the reality of politics. No avoiding it. Simon Wren-Lewis has a great post on this topic today, looking at why it would not actually be that hard -- conceptually -- to make the financial system more stable. The only barrier is the intimate connection between finance and politics ("quite frankly, the banks own this place" as U.S. Senator Dick Durbin once put it), which means that banks won't actually have to do things that might help the public good and the nation as a whole:

There is one simple and straightforward measure that would go a
long way to avoiding another global financial crisis, and that is to substantially increase the proportion of
bank equity that banks are obliged to hold. This point is put forcibly, and in
plain language, in a recent book by Admati and Hellwig: The Bankers New
Clothes. (Here is a short NYT piece by Admati.) Admati
and Hellwig suggest the proportion of the balance sheet that is backed by
equity should be something like 25%, and other estimates for the optimal amount of bank
equity come up with similar numbers. The numbers that regulators are intending
to impose post-crisis are tiny in comparison.

It is worth quoting the first paragraph of a FT review by Martin Wolf of their book:

“The UK’s Independent Commission on Banking, of which I was a
member, made a modest proposal: the proportion of the balance sheet of UK
retail banks that has to be funded by equity, instead of debt, should be raised
to 4 per cent. This would be just a percentage point above the figure suggested
by the Basel Committee on Banking Supervision. The government rejected this,
because of lobbying by the banks.”

Why are banks so reluctant to raise more equity capital? One
reason is tax breaks that make finance using borrowing cheaper. But non-financial
companies, that also have a choice between raising equity and borrowing to
finance investment, typically use much more equity capital and less borrowing.
If things go wrong, you can reduce dividends, but you still have to pay
interest, so companies limit the amount of borrowing they do to reduce the risk
of bankruptcy. But large banks are famously too big to fail. So someone else
takes care of the bankruptcy risk - you and me. We effectively guarantee the
borrowing that banks do. (If this is not clear, read chapter 9 of the book here. The
authors make a nice analogy with a rich aunt who offers to always guarantee
your mortgage.)

The state guarantee is a huge, and ongoing, public subsidy to the banking sector. For large
banks, it is of the same order of magnitude as the profits they make. We know
where a large proportion of the profits go - into bonuses for those who work in
those banks. The larger is the amount of equity capital that banks are forced
to hold, the more the holders of that equity bear the cost of bank failure, and
the less is the public subsidy. Seen in this way it becomes obvious why banks
do not want to hold more equity capital - they rather like being subsidised by
the state, so that the state can contribute to their bonuses. (Existing equity holders
will also resist increasing equity capital, for reasons Carola Binder summarises based on the work of Admati and
Hellwig and coauthors.)

This is why the argument is largely a no brainer for economists. [1] Most economists are
instinctively against state subsidies, unless there are obvious externalities
which they are countering. With banks the subsidy is not just an unwarranted
transfer of resources, but it is also distorting the incentives for bankers to
take risk, as we found out in 2007/8. Bankers make money when the risk pays
off, and get bailed out by governments when it does not.

So why are economists being ignored by politicians? It is
hardly because banks are popular with the public. The scale of the banking
sector’s misdemeanours is incredible, as John Lanchester sets out here. I suspect many will think that banks are
being treated lightly because politicians are concerned about choking off the
recovery. Yet the argument that banks often make - holding equity capital
represents money that is ‘tied up’ and so cannot be lent to firms and consumers
- is simply nonsense. A more respectable argument is that
holding much more equity capital would translate into greater costs for bank
borrowers, but David Miles suggests the size of this effect would not be
large. (See also Simon Johnson here, John Plender here and Thomas Hoenig here.) In any case, public subsidies are bound
to be passed on to some extent, but that does not justify them. Politicians are
busy trying to phase out public subsidies elsewhere, so why are banks so
different?

There is one simple explanation. The power of the banking lobby (and the financial industry more generally) is immense, from campaign
contributions to regulatory capture of various kinds. It would be nice to imagine that the UK
was less vulnerable than the US in this respect, but
there are good reasons to think otherwise. [2] As a result, the power and
influence of banks and bankers within government has hardly suffered as a
result of the Great Recession that they played a large part in creating.

This point bears repeating -- indeed, it ought to be repeated every day for the rest of the year. All the technical and semi-technical articles now being published about measures for getting at systemic risk and improved schemes for weighting capital and so on, however clever and interesting they may be, actually only serve to draw attention away from this most serious problem, which is institutionalized corruption plain and simple. If every finance professor wrote one article on this topic -- after all, shouldn't this really be THE main topic in finance today? -- we might one day get somewhere with fixing the financial system.

Monday, August 26, 2013

I had the opportunity last week to speak at the Edinburgh International Festival of Books alongside Tony Juniper, British environmentalist and former head of Friends of the Earth. I highly recommend his new book, What has nature ever done for us?, which examines the many ways that the natural world contributes to our well being considered in economic terms. "Many ways" is of course an absolutely absurd understatement, as the natural world essentially provides everything that makes our lives possible. But if you turn off your brain, swallow hard and actually do calculations of environmentally produced economic value -- sadly, it seems that only this approach has influence in our world where everything comes down to economic costs and benefits -- you find (without any surprise) that the value of "ecosystem services" on a yearly basis is many times current global GDP.

Personally, I think it is obvious that this is a vast underestimate, but if it is necessary to convince people who cannot think in any other terms, then so be it. The Earth's ecosystems produce the oxygen we breath. How much value is there in that? I would say it is pretty much infinite, although I'm sure someone will argue that we could, with the right hypothetical technology, produce our own oxygen and so replace those messy natural resources with industry based on our own knowledge, perhaps we'd even boost the economy in the process! Bollocks. Juniper's book is a beautifully written corrective to such nonsense.

We've evolved in delicate interdependence with our natural world; we didn't create ourselves above and beyond nature with rational thought and technology, although this is the modern illusion. Although it comes from a very different context -- A Recipe for Happiness by Rabbi Ari Kahn (courtesy of Mitch Julis of Canyon Partners) -- I think the following words hold great wisdom:

Modern man, intoxicated with his own success, is prone to hubris. He sees himself as a self-made man, and worships his ‘creator’ every time he glances in the mirror... Like Narcissus gazing into the water while perched on a rock, modern man no longer recalls where he came from, and his own self-absorption mesmerizes him. He is isolated, and because he has forgotten the past, he has no humility, no perspective, no context. At the same time, he jeopardizes his connection with the future: Only when we transmit historical consciousness to our children, and live beyond the narrow confines of the present, do we stand a chance of being appreciated by our children – rather than being rejected, in turn, as a relic from the past.

Tuesday, August 6, 2013

I'm getting back tomorrow from extended travels in Poland and the UK and hope to resume some more frequent blogging. Just a quick note today to clarify my recent column in Bloomberg on Homo economicus and the payoffs to friendly types in Prisoner's Dilemma games. Several people commenting on Bloomberg have suggested that what I've said was known 20 years ago or was all evident from the famous work of Robert Axelrod on the iterated Prisoner's Dilemma. They don't seem to have taken a look at the specific paper I referred to in the piece, which is very recent, but maybe that's my fault as I didn't spell out what is new about this work as well as I could have.

This study by Thomas Grund and colleagues does not JUST look at the iterated Prisoner's Dilemma or point out that mechanisms of group selection can support the evolution of altruists. This is indeed already known and has been known for a while. However, these mechanisms are also subject to limitations depending on various factors such as group mixing. The current study looks at a situation in which individuals CAN care about the payoffs for others with whom they interact (their utility function has an other-regarding component). It assumes that this does NOTHING for their reproductive fitness, however, this being totally distinct from utility and depending on an individual's own payoff. In other words, the model assumes that helping behavior is costly.

So, why would someone come to care for about the payoffs to others? Why indeed. This is where the story gets interesting. Just let this be possible by giving everyone a "friendliness" parameter F reflecting how much they care about others (0 = no caring, 1 = a lot of caring). What the study shows is that, even if everyone starts out with F = 0, this situation is unstable to the evolution of caring behavior. If individuals pass on their friendliness (genetically or culturally) to offspring, then random variations in friendliness values, caught on the wing by selection, can spread through the population. In effect, friendliness, even though it matters not for actually fitness, can provide an organizational scaffolding that makes it easier for cooperators to find cooperators. The mere possibility of friendliness (you can call this arbitrary variable anything you like) allows a spatial segregation of the population that enables much higher levels of cooperation.

This is, I think, quite new and very different from earlier studies. It introduces an essentially new element. Homo economicus, in this world, suffers because he is not capable of responding as flexibly as are others in the population (i.e. making decisions on the basis of matters that have no link whatsoever to his fitness). Those who are more flexible -- and apparently unreasonable -- can come to dominate quite quickly in the right circumstances. From the paper:

However, why does this transition happen in just a few generations (see Fig. 1B),
i.e. much faster than expected? This relates to our distinction of
preferences and behaviour. When an ‘idealist’ is born in a neighbourhood
with friendliness levels supporting conditional cooperation, this can
trigger off a cascade of changes from defective to cooperative
behaviour. Under such conditions, a single ‘idealist’ may quickly turn a
defective neighbourhood into a largely cooperative one. This implies
higher payoffs and higher reproduction rates for both, idealists and
conditional co-operators.

The intriguing phase transition from
self-regarding to other-regarding preferences critically depends on the
local reproduction rate (see Fig. 2).
The clustering of friendly agents, which promotes other-regarding
preferences, is not supported when offspring move away. Then, offspring
are more likely to encounter defectors elsewhere and parents are not
‘shielded’ by their own friendly offspring anymore. In contrast, with
local reproduction, offspring settle nearby, and a clustering of
friendly agents is reinforced. Under such conditions, friendliness is
evolutionary advantageous over selfishness.

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This blogexplores the potential for the transformation of economics and finance through the inspiration of physics and the other natural sciences. If traditional economics has emphasized self-regulation and market equilibrium, the new perspective emphasizes the myriad positive feed backs that often drive markets away from equilibrium and cause tumultuous crashes and other crises. Read more about the idea.

Who am I?

Physicist and science writer. I was formerly an editor with the international science journal Nature and also the magazine New Scientist. I am the author of three earlier books, and have written extensively for publications including Nature, Science, the New York Times, Wired and the Harvard Business Review. I currently write monthly columns for Nature Physics and for Bloomberg Views.